Capital budgeting is a financial analysis tool that applies quantitative analysis to support strong management decisions. Using capital budgeting analysis, you can explain:
- The benefit impact of an investment decision over time
- The cost impact of an investment decision over time
- The risk factors associated with an investment, both immediately and in the future
- And develop a financial model that accounts for all of these factors and presents the results in a usable fashion.
Capital budgeting is not just a quantitative modeling exercise, however. The goal is creating a clear and simple picture of the benefits, costs, and risks associated with a possible business investment in both the short term and the long term.
The information presented in this article, plus a basic understanding of finance theory and discounted cash flow analysis techniques such as net present value (NPV), modified internal rate of return (MIRR) and investment payback can help you improve the structure, balance, and impact of your next capital budgeting analysis.
The trouble with traditional methods
The model that you use for capital budgeting must be flexible enough to paint an accurate picture of the investment. Many capital budgeting or return-on-investment (ROI) templates are not flexible enough, providing a poor basis for decision-making in some cases. For instance, the benefits, costs, and risks associated with a technology investment are different from those for a typical "hard" asset investment.
Too often, the focus of decision-making based on capital budget analysis shifts toward the end results of the ROI model, and the assumptions that support those results, rather than a balanced analysis of benefits, costs, and risks.
Using a recent analysis or reusing templates that are not specific to your needs might cause your analysis to be flawed, skewed, or noninclusive of important factors. The assumptions used might be insufficient or unsupported, which might put you in the position of defending your numbers, rather than offering information to help make a good business decision. If the project does not have a clear strategic or financial benefit, the request might be shelved for further analysis or shot down completely, leaving you and your requestor to wonder what you could have done differently.
Looking at the leading practices
When too much attention is placed on the assumptions and end results of the ROI analysis alone, the net business benefits versus the risks associated with making the investment are ignored. Restructuring your capital budgeting analysis to promote a balance between quantitative analysis and benefit versus risk analysis with an understanding of the difference between technology investments and traditional "hard" investments helps requestors and committees make better business investment decisions. Leading practices in capital budgeting consider more than just the quantifiable factors.
Consider the nature of the request
The type of benefit gained by the potential investment determines the nature of the request. There are three distinct benefit types: strategic, quantifiable, and intangible. Intangible benefits are hard to quantify, but they can have a big impact. These three benefit types form the business case, regardless of the type of investment. You should take care to highlight the primary benefit type in your analysis, because capital budgets tend to focus on quantifiable benefits.
For example, a purely quantitative ROI analysis for an enterprise resource planning (ERP) implementation 10 years ago would have made it look like a bad business choice, because a common systems platform is expensive without demonstrable payback. But, from today's viewpoint, that decision would have been a poor strategic choice and the company making it might now be out of business. In this case, the strategic benefits were more important than the quantifiable benefits in making a good business decision.
Understanding the role of quantification within the overall business case is important. If an investment decision should be weighted toward strategic factors or intangible factors, your analysis must reflect and support that aspect of the potential investment, without overemphasizing or inflating to meet a payback or NPV threshold.
All benefits are not created equal
Benefits must be classified correctly to be analyzed correctly. You can quantify benefits in two ways:
- Hard benefits Benefits that affect the profit and loss statement (P&L) directly. These benefits might be reduced staffing levels, reduced rework due to defects, improved net revenue net from cannibalization, or improved margins.
- Soft benefits Quantifiable benefits that don't directly affect P&L. Productivity gains are a good example (rises in productivity caused by reducing the effort or labor expense required per unit).
It's easy to quantify hard benefits and keep your audience's confidence. Quantifying soft benefits is a good practice, but unless they lead to reduced costs or higher revenues, soft benefits are not equal to hard benefits and shouldn't be lumped in with them.
If you provide a total benefit number based on a combination of hard and soft benefits together, your requestor and committee might reject it as "padded." They might throw out the soft benefits and recalculate the overall hard ROI metrics alone, having lost confidence in the overall integrity of your ROI model.
See the big picture
Ultimately, your analysis should support good decision-making. Some new investments can be very exciting, but it's wise to exercise some professional skepticism when identifying benefit drivers and the assumptions that support them. The benefit and response table offers a few examples.
|This new distributor allows us to market to the Texas region, bringing in $10M in new revenues next year.
||How many sales does our Southwest distributor already derive from Texas? Will this cannibalize some of their existing business?
|This new machine will allow us to produce 10% more widgets at the same cost.
||What are the costs associated with training on the new machine? What about loss of productivity while the machine is installed?
|This new point-of-sale application will allow us to capture retail sales data quicker and create more effective promotions.
||Do we need to upgrade aspects of our infrastructure to accommodate the new application? What is the cost of upgrading?
Considering the skeptical response during the analysis phase and answering it supports your model's overall credibility. You need a strong understanding of the business and industry that you are analyzing, as well as the specific business pains the proposed investment is supposed to solve.
Often, the focuses of capital budgets are the benefits and costs required for building the discounted cash flow analysis. Risk is often neglected, but it should be part of the discussion, analysis, and decision-making process. A high-risk project with a good return is less desirable than a lower-risk project with a similar return, but you cannot make an argument about risk-to-return relationships unless you can analyze risk.
Build a risk factor into your model. The risk factor represents the probability of the company reaping a specific benefit from the proposed investment. Where the probability of success is high, risk is low. You can apply this risk factor to the entire set of benefits. High-technology investments are often analyzed in terms of risk.
Present the risk analysis proactively as part of the business case, considering the major deployment risks as well as mitigating strategies to reduce those risks. This shifts the focus from the negative — what could go wrong — to the positive by balancing risk against mitigation and benefit.
Be realistic about benefit periods
Unrealistic expectations can undermine any analysis. There are two major sources of unrealistic benefit periods.
If the project sponsor expects the project to go forward without a hitch, he or she might anticipate reaping benefits too soon. Challenge these assumptions early in your analysis, because they can make a proposed investment look better than it really is.
Reusing models that reflect the depreciation period for the capital asset can also create unrealistic expectations. Instead, create your model with this question in mind: "What is the true useful life of this asset?" Accounting guidelines can give you a starting point, but if the asset definitely has a shorter or longer life, adjust your model accordingly, along with the associated benefits, costs, and risks.
Large software investments are a good case for adjusted models. Most companies use software for more than five years, where depreciation guidelines designed for hardware are usually based on a three-year useful life.
Focus on the audience
Understand how the capital committee wants the business case and supporting analysis presented. Presentation style, depth of analysis, and communication style are important to the way your analysis is received. You should also know who the decision-maker and the opinion leaders are within the committee and adjust your presentation to suit them.
Better capital budgets
Now that you're familiar with the techniques of leading capital budgeting specialists, you know that the ultimate goal of your work is providing appropriate quantitative support for a business case that challenges assumptions and answers those challenges, while also providing a balanced view of risks, costs, and benefits within realistic expectations. It's important to understand the nature of the business that you work in and apply appropriate models. When you use these techniques, you provide enormous value to the organization by providing better decision support, less rework, and more effective partnering with the business.
About the author BearingPoint provides business consulting, systems integration, and managed services to Global 2000 companies, medium-sized businesses, and government organizations.